Biggest Debt-Fueled Stock Market Bubble Ever

You saw last week how Warren Buffet’s most preferred valuation metric shows the stock market has returned to an irrationally exuberant Tech Bubble level. You also saw from 4 months ago that consumer sentiment was at a very rare and high level consistent with two past stock market bubbles. Ironically, credit growth is in decline as a growing number of companies slash and eliminate their dividends, suggesting the end of the another business cycle. If we are in a bubble, the question I have is: is this a dangerous one?

When are Bubbles Particularly Dangerous?

In an interview on CNBC, a renown economist spoke on the topic of bubbles. His 19-year tenure as Chairman of the Federal Reserve had him oversee two notable bubbles. I imagine he understands the topic very, very well. He explained (emphasis added):

Bubbles per se are not what the issue is. It is turning out to be bubbles with leverage. And leverage is critically important obviously because it is the only way you can get the issue of contagion going . . . – Alan Greenspan(October 23, 2013)

How much debt is too much debt?

I bring this topic up now because there is an unprecedented amount of financial leverage in the stock market. To understand how much, we need to take a close look at margin debt (“MD”). It is the money brokers lend their clients to buy securities. I prefer to normalize MD against the size of the economy by comparing it to GDP. You can see this in the graph below.

When MD/GDP exceeds 2.00%, as it did in in 1999 and 2007, the bubbles became evident despite widespread denial. The Tech and Subprime bubbles subsequently burst less than a year in each case. From peak to trough, the S&P 500 crashed (grey shaded areas) by 50% and 55%, respectively. MD/GDP of 2.00% has been a threshold in gauging excessive financial leverage.

The use of financial leverage in the stock market is at an unprecedented level.

More recently, MD/GDP exceeded 2.00% for the past 56 consecutive months. That is roughly 4-times and 3-times as long as the Tech (13 months) and Subprime Mortgage (19 months) bubbles, respectively! Furthermore, MD/GDP only a few months ago reached a new plateau of 2.86%. This may sound like a small number but it exceeds the previous bubble peaks of 2.78% and 2.62% of early-2000 (Tech Bubble) and mid-2007 (Subprime Mortgage Bubble), respectively.

Summary

It is crystal-clear to me the stock market is in another financially leveraged bubble. This one is unprecedented. It has extreme depth (2.86% of GDP) and immense breadth (56 consecutive months). If financial leverage is indeed the correct way of gauging the potential harm from the prospective aftermath, as Greenspan indicated, then this bubble could prove to be the biggest one ever.

Whether or not you believe dangerous bubbles are attributed to financial leverage, please consult an investment fiduciary before making any investment decisions. Should you be in search of an investment fiduciary, then Meritocracy Capital Partners Inc. would welcome the opportunity to serve as your partner.

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Meritocracy Capital Partners Inc. (“we”) is a boutique investment management firm and Portfolio Manager that closely aligns itself to its clients. We build trust and accountability by providing a fee structure driven by performance and by having our money invested right alongside our clients’ money. As a result, we treat our clients’ money like our very own.